United States: California Court Of Appeal Allows Taxpayers To Elect Equally- Weighted Three-Factor Apportionment Formula Under Multistate Tax Compact

The California Court of Appeal has ruled in favor of a group of taxpayers electing to use the equally-weighted three-factor apportionment formula that is provided by the Multistate Tax Compact, in lieu of an apportionment formula requiring use of a double-weighted sales factor.¹ California originally adopted the Compact's equally-weighted three-factor apportionment formula, but enacted mandatory use of a double-weighted sales factor for most California taxpayers in 1993, notwithstanding the provisions in the Compact. Despite this legislation, the Court of Appeal held that California is contractually bound by the Compact and its apportionment election provision until it withdraws from the Compact.

Background

The Uniform Division of Income for Tax Purposes Act (UDITPA) was promulgated in 1957 in an effort to provide uniformity in the apportionment of corporate income among states. Under UDITPA, income is apportioned to a state using an equally-weighted formula that consists of property, payroll and sales factors.² The Compact, which was created in 1967, adopted the apportionment methodology from UDITPA. Specifically, Article IV of the Compact provides for an equally-weighted three-factor formula. Article III of the Compact expressly allows taxpayers the option of apportioning income under the standard UDITPA formula or a state's alternative apportionment provisions. California ratified the Compact in 1974³ and required corporations to apportion their business income to the state using the standard equally-weighted three-factor formula.⁴ For tax years beginning on or after January 1, 1993, California adopted a three-factor apportionment formula consisting of property, payroll and double-weighted sales, notwithstanding the Compact.⁵

In January 2010, the taxpayers filed claims with the California Franchise Tax Board (FTB) for the refund of taxes and argued that the California apportionment statute did not override or repeal the standard UDITPA apportionment formula. The taxpayers appealed the FTB's denial of their refund claims to the trial court.⁶ The FTB argued that the amended California apportionment statute required the exclusive use of the double-weighted sales factor and negated the taxpayers' claim of entitlement to elect the UDITPA formula. The trial court ruled in favor of the FTB and agreed that the California apportionment statute clearly expressed an intention to eliminate the alternative apportionment formula allowed under the Compact. The taxpayers appealed this decision to the California Court of Appeal.

Taxpayers Can Elect Compact's Apportionment Formula

The Court of Appeal reversed the trial court and agreed with the taxpayers that California was bound by the provisions of the Compact and could not override and eliminate the taxpayers' ability to elect UDITPA's equally-weighted three-factor apportionment formula. In reaching its decision, the Court rejected the FTB's argument that the plain language of the California apportionment statute requires the exclusive use of the double-weighted sales apportionment formula. According to the Court, California could only eliminate a taxpayer's election to use the equally-weighted three-factor formula by completely withdrawing from the Compact. California could not enact a statute that repeals the provisions of the Compact to the extent necessary to impose a mandatory apportionment formula on taxpayers.

Contractual Nature of Interstate Compacts

The Court explained that interstate compacts are binding and enforceable contracts between states. A compact takes priority over subsequent state legislation and cannot be amended unless all the members of the compact agree to the change. A state is unable to unilaterally amend a compact by enacting legislation unless the compact grants this power to the states.

Multistate Tax Compact Is An Enforceable Interstate Tax Compact

In U.S. Steel Corp. v. Multistate Tax Commission,⁷ the U.S. Supreme Court rejected constitutional challenges and upheld the facial validity of the Compact. By enacting the Compact as part of California law, California became a member of the Multistate Tax Commission (MTC). The California Court of Appeal noted that the apportionment election provision is not optional for states that have adopted the Compact. Because multistate taxpayers may elect either apportionment formula, the Compact member states must make the election available. The Compact provides that a state may withdraw by enacting a statute repealing the Compact. However, any repealing legislation must be prospective in nature.

States Cannot Unilaterally Repeal Compact Terms

The Court rejected the FTB's statutory construction argument that the language enacted in 1993 providing for the double-weighted sales factor "notwithstanding" the Compact overrode the Compact and the apportionment election provision. Under established compact law, the Compact supersedes subsequent conflicting state law. Also, the federal and state Constitutions prohibit states from passing laws that impair the obligations of contracts.⁸ Finally, the FTB's construction of the amended apportionment statute violates the re-enactment clause of the California Constitution.⁹

The Court determined that the statutory apportionment provision cannot override the apportionment election provision contained in the Compact. Because the Compact is both a statute and binding agreement among the states, California cannot unilaterally alter or amend its terms. The plain language of the Compact's withdrawal provision allows only for complete withdrawal from the Compact. The Court rejected the FTB's argument that the withdrawal provision should be interpreted to permit a partial repeal or unilateral amendment.

Commentary

The question of whether taxpayers are allowed to elect to use the equally-weighted three-factor apportionment formula in California has received considerable attention. Considering the importance of this issue and the large number of potential tax refunds involved, the FTB is considering its options, and will likely request either a rehearing of the case at the Court of Appeal level, or an appeal of the Court of Appeal's decision to the California Supreme Court (which appeal would be due in early September). If a petition to the California Supreme Court is filed, the Court would have discretion as to whether it would hear the case, but given the significance of this issue, it is likely (though not certain) that the Court would hear the case. Therefore, barring the FTB's acquiescence in the result at the Court of Appeal, a final determination in this matter is not expected for some period of time.

In contemplation of a decision adverse to the state, California enacted legislation on June 27 repealing the Compact.¹⁰ The legislation, which was an attempt to limit the tax refunds that the state might be required to pay for open tax years, clarifies that since 1993, the use of an equally-weighted three-factor formula by a multistate taxpayer has been disallowed. Pursuant to the legislature's finding and declaration contained in the bill, an election that affects the computation of tax must be made on an originally timely filed return for taxable period for which the election is to apply.¹¹ Questions already have been raised by the state's attempt to retroactively withdraw from the Compact, which was explicitly challenged by the Court's ruling that only a prospective withdrawal would be acceptable. Further, a potential argument that the state's withdrawal from the Compact was ineffective could be raised, in that California implicitly enacted a tax increase when it withdrew from the Compact, and pursuant to Proposition 26, all tax increases must be approved by a two-thirds margin in the state Assembly and Senate. As the state legislature did not pass the legislation by the required supermajority margins, the withdrawal from the Compact may have been ineffective.

In this case, the taxpayers filed amended returns to make the Compact election resulting in refund claims. While the Court's holding implicitly endorsed the ability of the litigating taxpayers to make the Compact election on amended returns, the Court did not generally address the consequences of making an apportionment (or any other) election on an original California return as opposed to an amended return.

With ongoing litigation, and controversial legislation on the books in California, taxpayers will be forced to deal with a fair amount of uncertainty and some decisions in the near future. Taxpayers with open tax years should seriously consider whether electing Compact apportionment treatment on an amended return is appropriate. Further, an election for original returns, particularly those covering tax years ending prior to California's actual withdrawal from the Compact on June 27, 2012, should be considered as well. For calendar year taxpayers, original returns for the 2011 tax year that were put on extension this spring are due on October 15, 2012. It would stand to reason that California's withdrawal from the Compact prior to the due date of the extended original return, by itself, would not prevent a taxpayer from making the election on the 2011 tax return, since such withdrawal occurred following the close of the 2011 tax year.

In thinking about whether to make the Compact election, ancillary issues will arise. For example, the potential for substantial understatement penalties (including the mandatory 20% large corporate underpayment penalty) could exist if the Compact election is made on an original return and the case is overturned at the California Supreme Court. If the Compact election is made on an amended or original return, taxpayers will have to follow all allocation and apportionment provisions contained in article IV of the Compact, which may be different than some of the California statutory provisions required to be used. The Court's ruling might have application in other states following the Compact that purportedly eliminated the ability to make the three-factor election through statutory legislation in years past, like California. Finally, given all the uncertainty and potentially large effect on state tax liabilities, the ASC 740 effect of making the election may be considerable.

Footnotes

1 The Gillette Co. v. Franchise Tax Board, California Court of Appeal, First District, No. A130803, July 24, 2012.

2 UDITPA § 9.

3 CAL. REV. & TAX. CODE §§ 38001 to 38021.

4 CAL. REV. & TAX. CODE § 25128(a) as in effect for tax years beginning prior to January 1, 1993.

5 CAL. REV. & TAX. CODE § 25128(a). Note that there are certain industry exceptions to the standard apportionment formula, including agriculture business, extractive business, savings and loan activities, and banking and financial businesses. These entities continue to use an equally-weighted three-factor formula. CAL. REV. & TAX. CODE § 25128(b), (c).

6 The case was considered by the San Francisco Superior Court.

7 434 U.S. 452 (1978)

8 The U.S. Constitution provides that "[n]o state shall . . . pass any . . . law impairing the obligation of contracts . . . ." U.S. CONST. art. I, § 10, cl. 1. Under the California Constitution, a "law impairing the obligation of contracts may not be passed." CAL. CONST. art I, § 9.

9 The California Constitution provides in part that "[a] statute may not be amended by reference to its title. A section of a statute may not be amended unless the section is re-enacted as amended." CAL. CONST. art IV, § 9. The FTB's argument would trigger this provision because it contended that the amended apportionment statute repealed and superseded the UDITPA apportionment formula.

10 Ch. 37 (S.B. 1015), Laws 2012.

11 S.B. 1015, § 4(a).

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